Risk Management of U.S.
Money Center Banks
Presented
by:
Wei Chen
Bridge Hu
Eric Song
Jing Zhang
Yuan Su Zhi
Agenda
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Industry Overview
Market Dynamics
Risk Management Environment
JP Morgan Chase
Merrill Lynch
Bank of America
Recommendation
Definition of Money Center Bank
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Money center bank: a large bank in a
major financial center which borrows from
and lends to governments, corporations,
and other banks, rather than consumers
Market maker: a brokerage or bank that
maintains a firm bid and ask price in a
given security by standing ready, willing,
and able to buy or sell at publicly quoted
prices (from their own accounts)
Products and Services
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Personal banking
Business banking
Investment banking – advisory, debt and
equity underwriting, market making, trading
and investing of debts and equities
Treasury and Securities Services – cash
management, institutional trust services,
treasury services, clearing services
Investment management and private
banking
Private equity – venture capital
Market Dynamics

Global money
center banks
-
market
capitalization =
1,221B
ROE = 16.9%

Merrill Lynch (56B)
-
U.S. Money
Market
Center Banks Capitalization
Citigroup
246B
Bank of
America
114B
Wells Fargo
95B
JP Morgan
Chase
73B
Wachovia
61B
US Bankcorp
52B
Bank One
47B
Important Regulations
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The Securities Exchange Act - established
the Securities and Exchange Commission
(SEC) as the primary regulator of US securities
markets, including investment banks as well as
non-banks that broker and/or deal non-exempt
securities
Financial Services Competition Act in 1999
permitted commercial banks to have affiliated
securities firms
Bank of International Settlements - Basel
Capital Accord
Financial Accounting Standards Board – FASB
Statement 133
Basel Committee
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Basel Committee
The Committee's members come from Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the
Netherlands, Spain, Sweden, Switzerland, United Kingdom
and United States
Countries are represented by their central bank and also by
the authority with formal responsibility for the prudential
supervision of banking business where this is not the central
bank.
The Committee does not possess any formal supranational
supervisory authority
It formulates broad supervisory standards and guidelines and
recommends statements of best practice in the expectation
that individual authorities will take steps to implement them
through detailed arrangements - statutory or otherwise which are best suited to their own national systems
FAS 133
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Accounting for Derivative
Instruments and Hedging Activities
(1998)
Result: substantially enhanced
information about derivatives
positions is now available in annual
reports
FAS 133 has been amended twice
already, by FAS 137 and FAS 138
The Major Risks Banks Face
1.
2.
3.
4.
5.
6.
7.
Liquidity risk
Interest risk
Market risk
Credit risk
Off-balance sheet risk
Foreign exchange risk
Operating risk
Liquidity Risk
Definition: risk of not be able to honor
bank’s financial commitments
promptly
It arises from an uncertainty of the
timing of cash flows
Liability-side risk results from
unexpectedly high rates of deposit
redemption
 Asset-side risk results from borrowers
unexpectedly drawing down loan
commitment
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Liquidity Risk
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Useful measurements
 The
net liquidity position, which
measures sources and uses of liquidity
 Peer
 The
group financial ratios
financing gap, which show the
degree to which loans are not financed
by core fund
Liquidity Risk Management

The fundamental dilemma of
liquidity risk management
 low
yield of reserve assets
 Liquidating investment
Liquidity Risk Management
Liquidity risk management is carried
out at both the retail and wholesale
level
1.
2.
3.
4.
5.
Demand deposit
Term deposit
Purchased money
Interbank borrowing
Repos
Interest Risk
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Definition: is the impact on banks
earnings and market value of equity
of changes in interest rates
 Refinancing
risk
 Reinvestment
risk
Interest Risk (measurements)
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Gap analysis
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Duration analysis
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Simulation model
Interest Risk Management
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Matching average life of assets and
liabilities reduces interest rate risk,
but it is not perfect hedge

Immunization requires dynamic
rebalancing of the portfolio, which
may be costly

To immunize the equity, set the
leverage adjusted duration gap
to zero
Market Risk
Definition: the risk of bank losses
from movement of market prices on
its trading inventory
Market Risk Measurement
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Two ways to measure
 Value-at-cost
 The
models (VAR)
BIS standardized measurement
method
Credit Risk

Definition: the risk of loss due
to the failure of a borrower,
endorser, guarantor or
counterparty to repay a loan or
honor another predetermined
financial obligation
Credit Risk Measurement
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Traditional approach
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Quantitative approach
Credit Risk Management
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Available collaterals
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Customers creditworthiness
Off-balance Sheet Risk
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Definition of off-balance sheet
activities: activities that do not appear
on the current balance sheet because it
does not concern holding a currency
primary claim(asset) or issuing a
current secondary(liability)
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Two categories: 1) Credit substitutes
2) Derivatives
Foreign Exchange Risk
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The potential adverse impact on
a bank’s earning and value of its
equity from foreign exchange
rate movement
Operating Risk
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It is business risk which includes
organizational behavior,
technological systems and legal
aspects of managing a bank
About JP Morgan Chase
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Leading global financial services firm with
operations in more than 50 countries
The merger of The Chase Manhattan
Corporation and J.P. Morgan & Co.
Incorporated was completed in December
2000
Assets of $793 billion; component of DJIA
No. 1 in global syndicated loans and asset
backed securities
No. 1 private bank in the U.S.
No. 5 in global M&A
No. 1 in U.S. dollar clearing and commercial
payments
No. 4 originator of residential mortgage loans
in the U.S.
Fourth largest domestic credit card issuer
Industry Standing
Five Business Segments
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Investment Bank
Investment Management & Private
banking
Treasury & Securities Services
JPMorgan Partners
Chase Financial Services
Two Brands
JPMorgan
 Investment bank, research, private equity,
treasury and securities services, asset
management, private banking
Chase
 Auto loans, checking, credit cards,
education loans, home equity, investments,
mortgage, online services, savings,
insurance
Revenue Structure
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Business segment: 44% of total
revenue from fixed income capital
markets
Client segment: 50% of total revenue
from financial institutions
Geographic region: 59% of total
revenue from North America
Revenue Structure
Risk Management Structure
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Risk Policy Committee of Board of
Directors – oversees risk management
Capital Committee – deal with firm-wide
capital planning, internal capital allocation,
and liquidity management
Risk Management Committee – deal with
credit risk, market risk, operational risk,
private equity risk, and fiduciary risk
Risk Management Structure
Capital Management
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Economic risk capital: assess capital
adequacy utilizing internal risk
methodologies
The methodology quantifies credit, market,
and operating risk (and private equity risk
for its private equity business) for each
business, and assigns capital accordingly
Liquidity Management
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Utilize liquidity monitoring tools through normal
and stress periods
Analytics rely on management’s judgment about
ability to liquidate assets or use them as
collateral for borrowings
Three primary measures of liquidity: holding
company short-term surplus, cash capital
surplus, and basic surplus
Derivatives: enter into derivative contracts to
swap fixed-rate debt to floating-rate obligations
and vice versa
Funding plan: use a variety of both short-term
and long-term instruments (including deposits,
federal funds purchased, repurchase
agreements, commercial paper, bank notes,
medium- and long-term debt, capital securities
and stockholders’ equity)
Credit Ratings for Funding Plan
Off-balance Sheet Arrangements
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Report off-balance sheet obligations and
commitments
Special-purpose entities (or specialpurpose vehicles)
SPE involves a company selling assets to
the SPE, which funds the purchase by
selling securities to investors
Critical to markets such as mortgagebacked securities, asset-backed securities,
and commercial paper
Off Balance-sheet Obligations and Commitments
Credit Risk Management
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Ensure that credit risks are accurately
assessed, properly approved, continually
monitored and actively managed
Assess on- or off-balance sheet exposures
including loans, derivative receivables and
lending-related commitments
To measure these risks, estimates are
made of both expected and unexpected
losses for each segment of the portfolio
using statistical techniques
Two functions: Credit Risk Policy and
Global Credit Management
Credit Risk Policy
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Formulate credit policies, limits, allowance
adequacy and guidelines
Independent from the groups that approve
and support credit activities
Manage problem credits
Global Credit Management
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Three functions: Credit Risk
Management, Corporate Banking, and
the Credit Portfolio Group
The first two participate in client coverage,
are responsible for approving and
monitoring all credit exposures
The last one manages the firm’s credit
exposures resulting from both traditional
lending and derivative trading activities
Credit Portfolio
Commercial Portfolio
Consumer Portfolio
Credit Management in Derivatives
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Use the same credit risk management
procedures to assess and approve potential
credit exposures when entering into
derivative transactions as those used for
traditional lending
Use mark-to-market value of the contract,
or the cost to replace the contracts at
current market rates should the
counterparty default, to measure credit risk
exposure
Dynamic management: adjust and
rebalance hedges as market conditions
change, such as counterparty’s credit
quality
Mark-to-market Fair Value of Derivative Contracts
Risk Profile of Derivative Receivables
Use of Credit Derivatives
Allowance for Credit Losses
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Intended to cover probable credit losses
The Risk Management Committee reviews
the allowance for credit losses relative to
the risk profile of the firm’s credit portfolio
and current economic conditions, and
adjusts it accordingly
Summary of Allowance and Provision for Credit Losses
Market Risk Management
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Corporate function: identify, measure,
monitor and control market risk
Seek to facilitate efficient risk/return
decisions and to reduce volatility in
operating performance
Individual coverage teams are assigned to
particular businesses where they have
expertise in the specific types of risk
Market Risk Measurement
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1.
2.
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1.
2.
3.
Statistical risk measures:
Value-at-Risk (VAR)
Risk identification for large exposures
(RIFLE)
Nonstatistical risk measures:
Economic value stress tests
Net interest income stress tests
Other measures of position size and
sensitivity to market moves
Value-at-Risk
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Measure the dollar amount of potential loss
from adverse market moves in an ordinary
market environment
Used to compare risks across businesses, to
monitor limits and to allocate economic
capital
Back-testing of VAR against actual financial
results to evaluate the soundness of the
model
Stress-testing: capture exposure to unlikely
but plausible events in abnormal markets
(VAR – loss due to unlikely events in normal
markets)
VAR and stress-testing are important
determinants in capital allocation for market
risk
Value-at-Risk: Aggregate Portfolio
Daily Market Risk-related Losses VS. VAR
Market Risk Monitoring and Control
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Limits – examine factors such as market
volatility, product liquidity, business track
record, and management
Qualitative risk management – review
business strategy, market conditions,
product details and effectiveness of risk
controls
Model review – review risk models to
assess appropriateness and consistency
across businesses
Policies and procedures – specify a clear
set of objectives, responsibilities, and
procedures
Operational Risk Management
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Maintain a system of comprehensive
policies and a control framework designed
to provide a sound and well-controlled
operational environment
Reputational risk: during 2002, the firm
put in place an additional structure to take
account of the potential for adverse
reputational impact of transactions with
clients, especially complex derivatives and
structured finance transactions
Operational Risk Management Practices
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Governance structure
Operational risk policies and procedures
Operational Risk Committee
Business Control Committees
Self-assessment process
Focused on business-specific key risks and controls
Automated using Horizon software application
Develop and monitor action plans
Operational risk event monitoring
Internal error and loss data reported and analyzed to
determine causal effects
Enables comparative analysis with external data
Alignment with internal audit activities
New capital allocation methodology (2003
Implementation)
Merrill Lynch
Company Overview
Merrill Lynch:
One of the world's leading financial
management and advisory companies, with
offices in 36 countries and private client
assets of approximately $1.1 trillion. As an
investment bank, it is a leading global
underwriter of debt and equity securities
and strategic advisor to corporations,
governments, institutions and individuals
worldwide. Through Merrill Lynch
Investment Managers, the company is one
of the world's largest managers of financial
assets.
Risk Management Philosophy
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Risk-taking is an integral part of Merrill
Lynch’s core business activities.
In the course of conducting its business
operations, Merrill Lynch is exposed to a
variety of risks including market, credit,
liquidity, operational, and other risks that
are material and require comprehensive
controls and ongoing management.
The Corporate Risk Management
(“CRM”) group, along with other control
units, works to ensure that these risks
are properly identified, monitored, and
managed throughout Merrill Lynch.
Corporate Risk Management Process
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A formal risk governance organization that
defines the oversight process and its
components
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A regular review of the entire risk
management process by the Audit
Committee of the Board of Directors
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Clearly defined risk management policies
and procedures supported by a rigorous
analytical framework;
Corporate Risk Management
Process - cont
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Communication and coordination between
the business, executive, and risk functions
while maintaining strict segregation of
responsibilities, controls, and oversight
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Clearly articulated risk tolerance levels as
defined by a group composed of executive
management (“the Management Group”)
which are regularly reviewed to ensure that
Merrill Lynch’s risk-taking is consistent with
its business strategy, capital structure, and
current and anticipated market conditions.
Risk Governance Structure
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Merrill Lynch’s risk governance
structure is comprised of the Audit
Committee, the Management
Group, the Risk Oversight
Committee (“ROC”), the business
units, CRM, and various corporate
governance committees.
Risk Governance Structure
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The Audit Committee
The Management Group
The ROC
Various other governance
committees
Corporate Risk Management
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CRM is an independent control
function responsible for Merrill
Lynch’s market and credit risk
management processes both within
and across the firm’s business units

The co-heads of Risk management
joined by other units such as
Finance and Legal Corporate Audit
Risks
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Market risk
Credit risk
Operational risk
Liquidity risk
Market Risk (VaR)
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Trading
Market Risk (VaR)
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Non-trading
Credit Risk Management
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CRM’s Credit Risk Group assesses the
creditworthiness

Credit risk mitigation techniques include
the right to require initial collateral or
margin, the right to terminate
transactions or obtain collateral should
unfavorable events occur, the right to
call for collateral when certain exposure
thresholds are exceeded, and the
purchase of credit default protection.
Credit Risk Management

Merrill Lynch enters into International
Swaps and Derivatives Association, Inc.
master agreements or their equivalent
(“master netting agreements”) with
substantially all of its derivative
counterparties as soon as possible.
The agreements are negotiated with
each counterparty and are complex in
nature.
Credit Risk Management
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In addition, to reduce default risk, Merrill
Lynch requires collateral, principally
cash and U.S. Government and agency
securities, on certain derivative
transactions.
To further mitigate its default risk on
derivatives whenever possible by
entering into transactions with
provisions that enable Merrill Lynch to
terminate or reset the terms of its
derivative contracts.
Credit Risk Management
• Credit exposure from derivative transactions
Operational Risk
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Maintaining a comprehensive
system of internal controls
Using technology to automate
processes and reduce manual
errors, monitoring risk events,
Employing experienced
personnel
Operational Risk - cont
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Monitoring business activities by
compliance professionals
Maintaining fully operational, offsite backup facilities, conducting
internal audits, requiring
education
Training of employees, and
emphasizing the importance of
management oversight.
Liquidity Risks
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Liquidity risks include both being
unable to raise funding with
appropriate maturity and interest
rate characteristics or being
unable to liquidate an asset in a
timely manner at a reasonable
price.
Liquidity Risks Management
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Maintain appropriate mix of short- and
long-term capital
Maintain sufficient alternative funding
sources
Concentrate unsecured financing at ML
& Co.
Diversify unsecured funding sources
Adhere to prudent governance
processes
Non-Investment Grade Holdings and
Highly Leveraged Transactions
(high-risk assets)
Non-investment grade holdings have
been defined as debt and preferred
equity securities rated as BB+ or lower
or equivalent ratings by recognized
credit rating agencies, sovereign debt
in emerging markets, amounts due
under derivative contracts from noninvestment grade counterparties, and
other instruments that, in the opinion of
management, are non-investment
grade.
Trading Exposures
Non-Trading Exposures
Valuation of Financial Instruments

Fair values for exchange traded
securities and certain exchangetraded derivatives, principally
futures and certain options, are
based on quoted market prices.
Valuation of Financial Instruments
- cont

Fair values for OTC derivative
financial instruments, which
represent amounts estimated to be
received from or paid to a third party
in settlement of these instruments,
are valued using pricing models
based on the NPV of estimated
future cash flows, and directly
observed prices from exchangetraded derivatives, other OTC trades,
or external pricing services.
Categorized Assets
1.
Highly liquid cash and derivative
instruments for which quoted market
prices are readily available
2.
Liquid instruments
3.
Less liquid instruments that are priced
using management’s best estimate of fair
value, and instruments which are valued
using a model, where either the inputs to
the model and/or the models themselves
require significant judgment by
management
Special Purpose Entities
(“SPEs”)

SPEs are trusts, partnerships, or
corporations established for a
particular limited purpose. Merrill
Lynch engages in transactions with
SPEs for a variety of reasons. Many
of these SPEs are used to facilitate
the securitization of client assets
whereby mortgages, loans or other
assets owned by clients are
transformed into securities
(“securitized”).
Company Overview
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No. 2 in U.S. in terms of revenues
No. 2 in U.S. in terms of assets
No. 3 debt arranger (underwriter) of
global loans, international bonds,
and medium-term notes.
More than 100,000 Bank of
America associates provide
financial products, services
Cont’d
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Their consumer and commercial
banking operations serve more than
one in four households in the United
States
Bank of America is U.S.’s No. 1
small business lender
Bank of America Investment
Services Inc., offers more than
820,000 account holders for wealth
management
Risk Management Overview
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Corporate Governance Structure
-Liquidity
-Credit
-Market
-Operational
Governance Structure

Begins with Board of Directors. The
Board of Directors evaluates risk
through the Chief Executive Officer
(CEO) and three Board committees:
-Finance Committee reviews market,
credit, liquidity and operational risk
-Asset Quality Committee reviews credit
risk
-Audit Committee reviews scope and
coverage of external and corporate
audit activities
Three Lines of Defense
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Lines of business
Risk management joined by other
units such as Finance and Legal
Corporate Audit
Senior Management Committees
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The Risk and Capital Committee
(RCC)
The Asset and Liability
Committee (ALCO)
The Credit Risk Committee
(CRC)
Liquidity Risk
Management

Two primary levels:
-parent company
-banking subsidiaries

Finance Committee is responsible
for establishing the liquidity policy as
well as approving operating and
contingency procedures and
monitoring liquidity on an ongoing
basis

Parent company:
-Source: dividends received from its
banking subsidiaries and proceeds from
the issuance of senior and subordinated
debt, commercial paper and equity
-Uses: repayment of maturing debt and
commercial paper, share
repurchases,dividends paid to
shareholders and subsidiary funding.

Primary measure: Time to required
funding
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Banking subsidiaries:
-Source: customer deposits, wholesale
funding and asset securitizations and
sales
-Uses: repayment of maturing obligations
and growth in the core and discretionary
asset portfolios, including loan demand.
Discretionary portfolio consists of
securities, certain residential mortgages
held for asset and liability management
purposes, and our swap portfolio
ALCO regularly reviews the funding plan
for the banking subsidiaries and focuses
on maintaining prudent levels of
wholesale borrowing
Credit Rating
Balance Sheet
Deposits and Other funding Sources
Off-Balance Sheet Financing Entities
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Facilitate customers’ access to the
commercial paper markets
Receive fees for providing
combinations of liquidity, standby
letters of credit (SBLCs) or similar
loss protection commitments, and
derivatives to the commercial paper
financing entities
In January 2003, the FASB issued a
new rule that addresses off-balance
sheet financing entities
Capital Management
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Shares issued under employee plans
and unrealized gains on securities
These increases were offset by
share repurchases and dividends
paid
On October 23, 2002, the Board
approved a $0.04 per share, or
seven percent, increase in the
quarterly common dividend.
Credit Risk
Management

Commercial Portfolio Credit Risk
Management
-Assessment of the credit risk profile of an
individual borrower
-Risk rating

Consumer Portfolio Credit Risk
Management
-Statistical techniques are used
-Statistical models are built using detailed
behavioral and demographic information
Outstanding Loans and Leases
Nonperforming Assets and Net
Charge-offs


Routinely review the loan and lease
portfolio
These losses resulted from a
multitude of factors:business failures
as a result of financial reporting
fraud, the prolonged weak economic
environment and industry specific
issues.
Nonperforming Assets
Nonperforming Assets Activity
Allowance for Credit Losses


Conduct periodic and systematic
detailed reviews
The allowance for credit losses
represents management’s
estimate of probable losses in
the portfolio
Problem Loan Management
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
Assist borrowing companies in
refinancing with other lenders or
through the capital markets
Facilitate the sale of entire borrowing
companies or certain
assets/subsidiaries
-selling individual assets in the
secondary market
Market Risk
Management
Trading Risk Management
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

Trading account assets and liabilities
Derivative positions
Mortgage banking assets
Trading Activities Market Risk
Interest Rate Risk Management


Goal: to manage interest rate
sensitivity so that movements in
interest rates do not adversely
affect net interest income
What involved:
securities,residential mortgage
portfolio, Securities
Techniques



Complex sensitivity simulations are
used to estimate the impact
The Balance Sheet Management
division maintains a net interest
Income forecast utilizing different
rate scenarios
The overall interest rate risk position
and strategies are reviewed on an
ongoing basis with ALCO and other
committees as appropriate
Operational Risk
Management
Techniques



Corporate wide or business segment
specific policies and procedures,
controls and monitoring tools.e.g.
personnel management practices, data
reconciliation processes, fraud
management units, transaction
processing monitoring and analysis,
systems interruptions and new product
introduction processes
Company-wide quarterly selfassessment process
Identify key risk indicators
Structure
Recommendations


Disclose more detailed information
on specific derivative instruments
used in risk management
Generally well established risk
management models for each
institution given respective risk
management philosophies